On Tuesday, Across the Curve posted an alert which referenced a Bloomberg story about the rising level of credit stress in China:

China's credit-market gauges are triggering alarm bells, as banks grow cautious in lending to each other while investors prefer the safest government bonds. The spread between the two-year sovereign yield and the similar-maturity interest-rate swap, a gauge of financial stress, reached 121 basis points on Feb. 19, the widest in Bloomberg data going back to 2007. Two days later, the cost to lock in the three-month Shanghai interbank offered rate for one year reached an eight-month high of 94 basis points over similar contracts based on repurchase agreements, which are considered safer because they involve government securities as collateral. Billionaire investors George Soros and Bill Gross have drawn parallels between the situation in China now and that in the U.S. before the 2008 financial crisis, when traders gauged lending appetite by monitoring the difference between the London Interbank Borrowing Rate and the overnight indexed swap. Premier Li Keqiang's efforts to curb leverage in the world's second-largest economy by driving up borrowing costs need to be handled carefully to avoid wrecking confidence in the financial system, according to Nomura Holdings Inc.

As well, I recently highlighted a way of monitoring the level of stress in the Chinese financial system by watching the Dim Sum Bond (NYSEARCA:DSUM) to 7-10 year Treasury (NYSEARCA:IEF) pair trade (see How 2014 could be like 1929). Indeed, the DSUM/IEF pair has convincingly violated a relative uptrend that began in July 2012:

How will Beijing react? In the past, whenever China's economy has approached the edge and stared into the precipice, the leadership has blinked and come to the rescue with the same-old-same-old tools of infrastructure spending and credit creation. Indeed, it has continued to do so despite all the rhetoric about reform and allowing market forces to take a greater role in the economy.

Where are the reforms? Remember all of the concerns about excessive credit growth and the deflationary effects of reining the shadow banking system? Bloomberg recently reported that credit growth remains unabated:

Record new credit in China in January will help the economy maintain momentum while highlighting challenges for officials trying to limit the risk of financial turbulence from defaults and bad loans.

Aggregate financing, the broadest measure of credit, was 2.58 trillion yuan ($425 billion), the People's Bank of China said in a Feb. 15 statement. New local-currency lending was 1.32 trillion yuan, the highest level since 2010. Trust loans, under scrutiny because of default risks, were about half the level of a year earlier.

This chart from Asia Confidential shows China's social financing growth tells the story in a more graphical manner:

What about the worries about a financial contagion over the impending default of two trust products (see the discussion of China tail risk in How 2014 could be like 1929). Beijing blinked again and bailed out another trust product (via Zero Hedge).

Asia Confidential wrung its hands about the lack of proper policy response to the negative effects of reform:

There's been a lot of over-hyped talk of China tightening and deleveraging over the past few weeks. Sure, inter-bank rates and corporate bond yields have significantly increased over the past year. But if you include things such as central bank injections into the inter-bank market and unsterilised foreign exchange purchases - where the central bank buys foreign currency to maintain the partial dollar peg - it's clear there's been no net tightening at all.

As for deleveraging, figures released on China lending over the weekend should be enough to put that to bed. January lending was the highest in four years. More worryingly, total societal financing - a broad measure of credit including shadow financing - increased to 2.58 trillion yuan, smashing analyst estimates of 1.9 trillion yuan. China remains addicted to credit despite the racheting up of rates.

They suggested the policy solution was to allow market forces to become dominant more quickly:

The fact is that China's President, Xi Jinping, hasn't done nearly enough to deflate the country's credit bubble. He needs to do three things, and fast: 1) allow defaults of wealth management products so risk can be properly priced 2) accelerate structural reforms laid out late last year 3) lower Beijing's bottom line for GDP growth from 7% to a more realistic 6%. Without these initiatives, Xi risks a much larger economic blow-up in the not-too-distant future.

Reforms foiled once again? Despite recent market jitters over reduced property lending, Beijing has exhibited a pattern of pushing a reform agenda, but unwilling to bite the bullet when critical sectors of the economy get pushed to the edge. If history is any guide, the Chinese leadership will continue talking tough on reform, only to see its initiatives get watered down as they run up against entrenched interests.

As I write these words, Asian stock markets are mildly positive with the Shanghai Composite and the Hang Seng Index up moderately. ES futures are also in the green. Despite all the angst in the credit and FX markets, equity markets are betting that Beijing will blink yet one more time.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."

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